Days of defensive tobacco go up in smoke

US regulatory clamp down adds to disruption already hitting the sector

In H1 2018, British American Tobacco posted profits of £4bn, up a whopping 72% on the same six-month period in 2017. The company said its strategy was to “continue to grow” its combustible business while simultaneously investing in smoking alternatives in the years ahead.

However, investors were given a wake-up call on Thursday after the US Food and Drug Administration (FDA) confirmed reports from last week that it would seek a nationwide ban on menthol cigarettes and cigars in a crackdown aimed at reducing teenage use of flavored tobacco products.

A statement by the FDA commissioner Scott Gotlieb pointed to statistics from the 2018 National Youth Tobacco Survey (NYTS) which found a 78% increase in e-cigarette use among high school students and a 48% increase among middle school students. The total number of middle and high school students currently using e-cigarettes rose to 3.6 million, up 1.5 million from the previous year.

As more news outlets started to follow up The Wall Street Journal’s initial report last week, tobacco share prices started to react. By the end of play on Monday, BAT’s share price had sunk 10.6% while Imperial Brands had a softer landing of 2.2%.

BAT was punished particularly harshly by the markets after Barclays analysts estimated that its US sales of menthol cigarettes could be responsible for up to a quarter of its annual underlying earnings.

AJ Bell head of active portfolios Ryan Hughes says the US FDA clamp down should prompt equity managers to assess their current thinking and positioning when it comes to tobacco stocks. “It just forces you to reappraise how aggressive the regulator could be on this and to check pricing models for how any fines or regulatory clamp downs could affect profit expectations going forward.”

Hughes says: “Of course, it may well come out that the market has overreacted and the price suddenly becomes attractive again. But, in terms being able to rely on these businesses within a relatively benign environment, it’s clear that that’s changed.”

Tobacco at a premium to other staples

Fidelity Global Dividend fund manager Dan Roberts said he is not a fan of the tobacco sector “which is slightly unusual for an income fund”.

Next-gen products are disrupting the factors that have made the sector so attractive over the last two decades. Market shares are shifting, there is no visibility on tax treatment and brand equity becomes corrupted. “For most next-gen products the Marlboro brand can’t brand them Marlboro.”

Pointing to BAT in particular, Roberts says its debt has been creeping up, noting generally after paying out its £4.5bn dividend it has £2bn left to pay down its gross debt, which currently sits at £45bn. Debt is picking up across defensives, unlike sectors that have been scarred by the financial crisis, says Roberts, but tobacco is an area for concern because traditional products are being disrupted.

“Tobacco is actually sitting at a premium to other staples that don’t have any of those long-term issues,” Roberts said on Monday.

In the closed-ended space, the Securities Trust of Scotland, which sits in the Global Equity Income sector, sold its stake in BAT in summer at £38 a share, 25% higher than its current price.

It continues to hold Philip Morris, but this position has reduced from 9% several years ago to 2% today, due to high competition and uncertainty around regulation in the low-harm space, says portfolio manager Mark Whitehead.

Tobacco in ethical portfolios

Tobacco has long been among the exclusions in ethical investors’ portfolios. More recently, investors looking at environmental, social and governance metrics have also considered the implications of holding tobacco stocks.

Some investors believe that the harmful consequences of smoking are at odds with the UN’s Sustainable Development Goals, specifically number three which promotes universal “good health and well-being”.

Unicorn UK Ethical Income fund, managed by Fraser Mackersie and Simon Moon, is one of the rare ethical products in the UK Equity Income sector and does not invest in tobacco.

Jonathan Yousafzai, head of ethical at Thesis Asset Management, claims that the US FDA’s projected ban on menthol cigarettes and menthol vape pods will continue to have a negative impact on the profits of tobacco companies. The fund firm claims that more than 55% of BAT’s US revenue is generated from menthol products.

The sector has been side-lined, even by portfolios that are not ethically tagged, despite once being a stalwart of income-generating portfolios, says Yousafzai. “This has been a winning trade over the last 18 months as tobacco shares have slumped in the face of increasingly heavy-handed regulation from governments, particularly in the West.”

But others say that Big Tobacco’s plans to increasingly generate more of their revenues from e-cigarettes and smoking alternatives shows that they are responding to investor concerns about their social impact on society.

Unlike the exclusion policies operated by most ethical fund houses, asset managers with company-wide ESG policies, are often able to invest in tobacco companies if they consider the companies to be a good long-term investment.

Securities Trust of Scotland is one such fund. At a presentation for press held earlier in November, Whitehead said his tobacco allocation prompts questions from investors given the investment trust touts its ESG credentials.

“We still own Philip Morris as we believe they are extremely committed to work in partnership with regulators across the globe to offer products that are less harmful to those that use combustible cigarettes, and that they will be able to grow earnings and dividends as a result,” he says, and also points to the company’s public push for a smoke-free future. “It also has much lower exposure to menthol combustibles.”

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